What Do the Cash Method of Accounting and Sausages Have in Common?

"Laws, like
sausages, cease to inspire respect in proportion as
we know how they are made." (Although often
attributed to Otto von Bismarck (the Iron
Chancellor), this maxim was actually first made by
lawyer-poet John Godfrey Saxe, quoted in the University
Chronicle, p. 4 (March 27, 1869).)

Perhaps this statement has never been truer than
it is today. The creation of tax laws in Washington
is often labor-intensive and involves members of
Congress, their staffs, special-interest groups,
lobbyists, and other interested stakeholders. One
can assume that if tax legislation is riddled with
compromise, the actual negotiation and closed-door
discussions that produce the laws are unfriendly and
perhaps even hostile at times. As
a result, the process of drafting tax laws is
generally better left unseen.

However, such
negotiation and compromise are part of the process.
Affected parties have perhaps not only the right but
the obligation to educate those who are responsible
for creating and administering the tax laws. In this
light, the CPA community, both individually and
through the AICPA, can play a vital role. CPAs are
uniquely qualified through their expert experience
to provide Congress with not only theoretical
support for policy decisions but also practical
knowledge for all tax law proposals.

Congress
has launched a debate on comprehensive tax reform,
the likes of which the country has not seen since
1986. As a result, the AICPA, in fulfilling one of
its key roles as a leading professional
organization, has been active in monitoring and
educating Congress about the implications of various
tax reform legislative proposals.

Limitation of the Cash Method of Accounting:
The Proposals

In March 2013, House
Ways and Means Committee Chairman Dave Camp,
R-Mich., released a tax reform draft bill, Proposed
Tax Reform Act of 2013, that included Title II—Tax
Reform for Businesses. The 2013 proposal included
many tax reform measures that signaled the
committee's desire to proceed with major tax reform
in this legislative session. Among the various
proposals is a troubling provision that would
severely restrict individual owners of businesses
from using the cash method of accounting. In early
2014, Camp modified the 2013 proposal in favor of a
much more robust and comprehensive tax reform
package titled the Tax Reform Act of 2014. Like its
predecessor, the 2014 proposal included a similar
limitation on the use of the cash method of
accounting.

In the fall of 2013, former Sen.
Max Baucus, D-Mont., then chairman of the Senate
Finance Committee, proposed a discussion draft on
cost recovery and accounting that would also
restrict certain individual owners of businesses
from using the cash method of accounting.

Each of these proposals would force a large
number of existing cash-method businesses to adopt
the accrual method of accounting.

The cash
method of accounting has historically been
recognized as appropriate for individuals to use in
reporting their business dealings. The cash method
is easier to understand and administer than the
accrual method. Starting in 1986, certain entities
were not allowed to use the cash method of
accounting. However, many businesses could continue
to use it as long as the business profits and
activity would ultimately be taxable to individuals
(Sec. 448(a)).

The cash method of accounting
is currently permissible for businesses owned by
individuals, most partnerships, and S corporations,
unless the business maintains inventory (Sec. 448(a)
and Regs. Sec. 1.446-1(c)(2)). A C corporation, or a
partnership with a C corporation partner, generally
cannot use the cash method of accounting (Secs.
448(a)(1) and (2)) unless it is a personal service
corporation, has average annual gross receipts of
not more than $5 million, or is in the business of
farming (Sec. 448(b)).

The Camp proposal
would limit the use of the cash method of accounting
to only individuals conducting business as a sole
proprietorship and other forms of businesses with
$10 million or less in average annual gross
receipts. Under the Camp proposal, however, the new
rules would not apply to farming businesses, which
would continue to be subject to current-law
accounting rules. The Baucus proposal would limit
the use of the cash method of accounting to only
businesses (including sole proprietorships) with $10
million or less in average annual gross receipts.
Thus, both proposals would force all directly owned
businesses other than sole proprietorships, such as
partnerships and S corporations, with annual gross
receipts of more than $10 million, to adopt the
accrual method of accounting, regardless of the
nature of the business and even if it did not
maintain inventory.This proposed limitation could
lead businesses to alter their ownership and
business structure for the primary purpose of
qualifying to maintain the cash method of
accounting. When income tax outcomes drive business
decisions, unintended and undesirable business
consequences are often quick to follow.

It is
only fair to note that the proposals would double
the historical annual gross receipts applicability
standard. This portion of the proposals is
well-reasoned and should be supported. An increase
in the limit is appropriate, considering that the
current threshold has not reflected any inflation
factor. However, the other limitations on the use of
the cash method of accounting placed on partnerships
and S corporations make the overall proposal
unworkable.

Why CPAs Should Care

The
proposals would produce several direct and indirect
consequences harmful to U.S. businesses. They
would:

Discourage individuals
from forming partnerships if doing so would
cause them to be subject to the $10 million
annual gross receipts test;

Require partners and S corporation
shareholders to pay tax on income they have not
yet received; and

Increase the complexity and cost of
compliance by forcing these "cash
only" types of businesses to adopt the more
complicated accrual method of accounting.

In Washington, tax ideas often
require discussion for many years before they gather
enough support for passage. However, ideas that
raise revenue will often be adopted more quickly as
Congress seeks ways to offset proposed tax breaks
with new tax revenues in current legislative
proposals. According to the Joint Committee on
Taxation, under a dynamic scoring model, Camp's 2014
proposal would raise $23.6 billion of new tax
revenue over the next 10 years (Joint Committee on
Taxation, Estimated
Revenue Effects of the "Tax Reform Act of
2014" (JCX-20-14), p. 7 (Feb. 26,
2014)). The amount of projected revenue raised by
this proposal is significant, even by Washington's
standards. There is a real risk that the proposals
could be used in future unrelated bills as an offset
to fund new legislation.

What
the AICPA Is Doing

To better assist
lawmakers in understanding the implications of the
proposals, the AICPA has sent both houses of
Congress five letters (see one from August 2013) that
highlight the proposals' shortcomings and unintended
consequences, as well as the negative business
implications. In addition, the AICPA, its
volunteers, and its staff members have contacted
various congressional offices to provide detailed
personal explanations of how the negative
consequences will affect members and their clients.
On July 17, the AICPA submitted written testimony to the House
Committee on Small Business's Subcommittee on
Economic Growth, Tax and Capital Access.

The AICPA's advocacy efforts resulted in 71
bipartisan members of the House sending a letter to
Camp and Ways and Means Committee ranking member
Sander Levin, D-Mich., in November 2013, strongly
discouraging them from adopting Camp's initial
proposal. On Aug. 6, 2014, a bipartisan group of 46
senators sent a letter to Senate Finance
Committee Chairman Ron Wyden, D-Ore., and ranking
member Orrin Hatch, R-Utah, expressing concerns
about the measures included in Baucus's
proposal.

The AICPA will continue to provide
this same education and thought leadership whenever
a proposal to limit cash-basis accounting surfaces
in either house of Congress in the future.

What
AICPA Members Can Do

AICPA members can
help by taking a more active role in informing their
representatives and senators about the negative
implications of the proposals. This information can
be shared through phone calls, emails, and meetings
with lawmakers and their staff members. CPAs can
provide copies of the AICPA's comment letters and
testimony and emphasize that the AICPA generally
supports tax reform efforts; however, the AICPA and
its members strongly oppose the limitation on
cash-basis accounting.

If the AICPA and other organizations are not
proactive about educating members of Congress and
their staffers about the direct and indirect
negative consequences of limiting the cash method
of accounting, Congress could very well end up
including this provision or something very similar
to it in a future tax bill that becomes law.

Contributor

Troy
K. Lewis is a vice president at
Heritage Bank in St. George, Utah, an
adjunct professor of accounting and
taxation at Brigham Young University in
Provo, Utah, and vice chair of the AICPA
Tax Executive Committee.

The winners of The Tax Adviser’s 2016 Best Article Award are Edward Schnee, CPA, Ph.D., and W. Eugene Seago, J.D., Ph.D., for their article, “Taxation of Worthless and Abandoned Partnership Interests.”

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